University of California Energy Institute

This paper discusses alternative approaches that have been adopted around the world for guaranteeing the appropriate level of investment in electric generation capacity. We argue that long term reserves should be viewed as price insurance and be treated as a private good. However, political realities and asymmetries and distortions in risk management incentives may necessitate imposition of mandatory levels of such insurance on load serving entities. Furthermore, centralized markets may be needed as a supplement to bilateral contracting in order to facilitate efficient procurement of such insurance and to bridge the gap between the needs of generators and load serving entities with regard to duration of hedging instruments. We discuss the origins and shortcomings of capacity payments and capacity obligations and explain how long term supply contracts in the form of call options with premiums that depend on the contracts' strike prices can meet the need for ensuring supply adequacy and the financial health of the generator sector. We also outline a scheme where regulatory intervention in generation adequacy assurance takes the form of a hedging requirement imposed at the state level on load serving entities.